Hamish McRae: Changes are afoot, and 2013 is set to be 'interesting'. So how will that affect us?

Economic View

A long weekend gives us a chance to think a bit about the longer-term outlook.

Most of us can be forgiven for feeling a bit ground down by the relentlessly gloomy economic news: high debts, high inflation, slow growth, falling real incomes, higher taxes, and spending cuts. There is a global recovery taking place but we don't seem to be seeing much of it, and to say that it is worse in Greece is small comfort.

I am afraid there is not much that can be said that makes this any better, except perhaps that employment is looking quite encouraging: at least it is climbing, with more people getting jobs in the private sector than are being made redundant by the public sector.

At least there is some sort of recovery taking place, both in the UK and elsewhere in the world, and if past history is any guide, this growth phase will last around seven years before another recession comes along. There is time to sort things out.

That was the theme of the G8 summit in France – that now growth is more secure, attention could switch to cutting public-sector deficits and getting monetary policy back to normal. That set me thinking about the likely shape and duration of the recovery and, of course, the threats it faces. In particular, could there be some sort of mid-cycle dip in 2013?

A new paper by Smithers & Co notes that 2013 is going to be an interesting year, but why? Well, there are a number of big things happening in global economic governance. There may be a new American president. If it were Sarah Palin that would put the cat among the pigeons, but whoever is president will have to tighten fiscal policy, perhaps quite radically. Smithers points out that if there isn't a serious plan to cut the deficit the bond markets will become very nervous indeed, and if there is, then there will be a big squeeze on corporate cash flow and profits.

The new permanent European Stability Mechanism will be in place. Smithers notes that if there hasn't been a default by 2013, that will be the moment when it happens. The question then will be how great the pain will be and how it will be shared. Will taxpayers in Germany and France take most of the burden, or will part be transferred to the banks? If the banks lose money then they will have to raise yet more capital, and the cost of credit will rise further.

The third big change will be a new Chinese government. The country will be adjusting to somewhat slower growth after the helter-skelter ride of the past few years and there will be more emphasis on increasing living standards and less on increasing exports. But it is still a planned economy, and a planned economy that has led to severe internal strains, not least because of higher-than-expected inflation. So the question facing the new government will be whether China should become more "normal", that is to say, managed more in the way that the present developed world runs things.

If 2013 is likely to be an unsettling year – this seems to be the current consensus in financial circles – you then ask how financial markets will react ahead of these potential bumps. The normal pattern is for equity markets to signal turning points some three to six months ahead of an event. They did this both for the top of the boom and the bottom of the recession. So I suppose if there is to be a mid-cycle pause around 2013 then you would expect markets to head down next year. Until then, however, the consensus seems to be that shares will do quite well.

Make of this what you will. The thing I find most interesting is this idea of a mid-cycle pause. Growth is never a straight line and there are a number of reasons to expect a pause – not a double dip – before growth is secure again. There are global reasons, of course, and we will come to those in a moment, but if you simply focus here on the UK you can see that there is more "sorting out" to be done. There is the fiscal deficit, of which so much has been written and said. But there is also inflation. As you can see from the main graph, UK inflation has been consistently higher than in the eurozone and the US, but inflation everywhere has been heading up. That has to be brought down because if the central banks don't take action the markets will.

Or take UK house prices. They are flat at the moment and most predictions seem to be that they will remain so, or maybe head down a little. But by historical standards prices relative to earnings remain high at a little above four times earnings. Even if the long-term trend is up they are still somewhat overvalued, though not quite as over-valued as they were a couple of years ago. So we just need more time to adjust. If a pause in growth helped lead to several more years of stable prices, coupled with gradually rising earnings, that would get prices back to their long-term sustainable levels.

Now look around the world. The US has to get policies back to normal: a much smaller deficit and the end to printing money. Europe has to resolve the position of the countries in intensive care and prevent other eurozone members going the same way. (There is a lot of concern about Spain at the moment which has yet to surface fully.) China has to find a way of attaining more balanced growth without needing to scoop up all the world's energy and raw material resources as it does so.

Say all this and you see that a pause in global growth would not be altogether bad. The trouble for us in Britain is that there might be a pause before we have even got back to the last peak of output, and before we have made much progress on cutting the deficit. On the other hand, if a pause in growth in a year or two's time led to the growth phase being longer, say 10 years, then that would be a price worth paying. One thing is sure. There is nothing we in the UK can do about it either way. All we can do is plod on and pay back debts, personal and public, as fast as we comfortably can – and, meanwhile, just enjoy the May sunshine.

McKinsey report shows just how much Britain and the internet have clicked

Something much more cheering: the role the internet is playing in the British economy.

Mark Zuckerberg was given a less than enthusiastic reception when he told leaders at the G8 summit that excessive regulation would not work. While the communiqué welcomed the role of the internet in driving economic growth and personal freedom, it warned of its threat to privacy and the protection of intellectual property.

But how big a role in driving growth? McKinsey Global Institute has just published a report on this: Internet matters: The Net's sweeping impact on growth, jobs, and prosperity.

McKinsey looks at 13 countries and concludes that it adds an average 3.4 per cent to GDP. If you look at it as an industrial sector it is bigger than energy or agriculture. Further, it is still in its infancy but already is a key driver of living standards and job creation.

So which countries are most important in this internet economy? As you might expect the US is the leader, with 30 per cent of revenues and 40 per cent of internet income. But Sweden and the UK are proportionately doing even better. Sweden leads with 6.3 per cent of GDP in the internet economy, with the UK second with 5.4 per cent. Britons are avid on-line shoppers, spending more than anyone else.

McKinsey calculates that the net value we as individuals get is also higher than anyone else. British businesses, too, are good at getting value out of the internet in terms of performance coming top, ahead even of Sweden.

All that is interesting because the UK is not strong on high-speed access. We are just innovative shoppers and communicators. We are quite good, too, at using the internet to uncover celebrities who use the law to gag us, but perhaps that is not quite what McKinsey has in mind. Mr Zuckerberg understands it though.

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